The global technology sector supply chain has undergone significant changes the past few years, with the COVID-19 pandemic causing significant manufacturing and logistics disruptions, changes to supplier and vendor procurement, information technology (IT) spending surges to meet enterprise and end consumer needs, and higher purchase prices. The Russia-Ukraine conflict, which broke out in early 2022, was a pivotal moment injecting substantial macroeconomic uncertainty around the world. Since then, IT spending, which is highly correlated to global GDP growth rates, has deteriorated, and the trend is likely to continue.

Here, we discuss which areas within the tech supply chain will be most affected, based on inventory and near-term growth prospects. We also discuss key risks to our base-case scenario and potential rating impact on certain hardware and semiconductor companies.

Table 1

Elevated Inventory And Macroeconomic Headwinds: Is The Bottom Near?

We expect IT spending to be weaker before getting stronger, and elevated inventory is to blame.  Over the next couple of years, we see strong boosts to IT spending from secular growth drivers such as cloud computing, digital transformation, artificial intelligence and machine learning, electric and automated vehicles, and industrial automation. We're convinced that electronic content will be even more ubiquitous to help further productivity gains. However, our view on IT spending in 2023 points to decelerating growth.

Global IT spending is heavily influenced by macroeconomic conditions. We find the best way to describe the near-term outlook for the global economy as uncertain. S&P Global economists believe the resilience of the U.S. and European economies and optimism over China's exit from its zero-COVID policy provide a somewhat improved economic backdrop. Yet, they are also convinced that the global economy is not in the clear. The unexpected collapse of a few U.S. regional banks and Credit Suisse in Europe showed the rapid interest rate hikes over the last 12 months to tame inflation will have unintended consequences. Core inflation remains stubbornly high on both sides of the Atlantic, and central banks may need to keep rates elevated until 2024, barring an economic meltdown. China's growth restart is welcomed, but the payoff could largely be domestic and inflationary.

Our base-case scenario includes an IT spending growth forecast of 3.3% in 2023, supported by continued strength in software and IT services that more than offsets weakness in areas such as PC, mobile, and data center infrastructure. We also believe the semiconductor market will drop about 10% in 2023 as the global supply chain resets inventory. However, to put this in perspective, the lower chip sales forecast, although depressing, is after a pandemic-fueled expansion in which semiconductor industry revenue increased nearly 40% the past three years.

IT spending deceleration is already underway, but our forecast for a second half 2023 IT spending rebound is highly uncertain. The probability of a recession in the U.S. or Europe remains high. Layoffs, budget scrutiny, and delayed growth investments in favor of liquidity preservation are all common behaviors when near-term growth becomes elusive. The anticipated economic boost from China reopening is also not guaranteed. The surge in COVID-19 infection rates early this year and the more recent threat of flu outbreaks may lead to shutdowns in certain cities. Slower than expected growth of the Chinese economy is a possibility.

Historically, elevated inventory (chart 1) would imply a slower, U-shaped recovery instead of a quick, V-shaped one. This is because elevated inventory in the tech supply chain will have to be worked down, and end consumption will have to exceed production such that inventory normalizes, before growth can resume. As end demand and inventory vary among product supply chains, we anticipate the timing and pace of an eventual recovery will be uneven among the different product categories. In a recessionary environment, sales may be even more sluggish and inventory digestion may take longer, exacerbating the cyclical downturn.

Chart 1

Demand Pulled Forward And Consumer Spending Weakness Lengthen Recovery Timeline For PC And Smartphone End Markets

We find manufacturers, EMS, and distributors are the quickest to respond to changing demand dynamics because they are closest to customers in the tech supply chain. In contrast, component vendors and semiconductor suppliers, because of their respond function, are one step slower in reacting to shifts. As such, we tend to see higher variations in sales and inventory at component vendors and semiconductor suppliers, and the current business cycle is no exception.

Chart 2

Chart 3

Significant inventories were built across semiconductor and component vendors, computer manufacturers, EMS, and distributors. Our general view is that inventory should peak in the first quarter for most markets since they are shipping below end demand. For component and semiconductor suppliers, their inventory peak would correspondingly be closer to the second quarter. Among the various products and end markets, we are most concerned about PC, smartphones, and those with most consumer exposure.

PC

PC vendors have been outsize beneficiaries of the pandemic-induced buying spree. Worldwide PC unit shipments took a roller coaster ride over the past few years with shipments of 275 million in 2020, 341 million in 2021, and 286 million in 2022, according to Gartner. These were significantly higher than the 262 million units shipped in 2019, boosted by demand pull-forwards from the collaborative hybrid work and learning environment born of necessity following the COVID-19 outbreak. Key industry metrics include unit installed base, length of refresh cycle, and average selling price (ASP). Although we support the assertion that richer configurations should help raise ASPs, we're less certain that the surge in PC unit shipments the past few years have significantly increased the PC installed base above historical norms or that the PC replacement cycle would be shorter, as some suggest. Weakness in the PC market began in March 2022, but it is still unclear whether the deterioration is in the rearview mirror. In the first half of 2023, we anticipate continuation of trends seen in recent quarters: A sluggish end demand environment, PC makers and channels focusing on clearing inventory, competitive pricing pressure, and commercial PC sales remain challenged given tighter IT budgets, but still better than consumer PC sales. Normal seasonality, in addition to progress in clearing excess inventory, would suggest the second half being stronger than the first. However, growth could be mild and limited to inventory replenishment if macroeconomic conditions do not cooperate.

Dell Technologies Inc., which employs a just-in-time manufacturing model, expects unit shipments to drop about 10% in 2023, whereas HP Inc. sees a decline in its fiscal 2023 in the mid-teens percent area, higher due to elevated channel inventory.

Table 2

Sales of x86 CPUs reached a cyclical peak in late 2021, about a quarter ahead of PC unit shipment cyclical peak. Since then, the PC market has been on a precipitous decline, with unit shipments down about 16% in 2022. Sales of x86 CPUs were even worse as seen with Intel Corp.'s client computing group revenue down 22% and Advanced Micro Devices Inc.'s (AMD) client segment revenue down 10%.

The cyclical trough in PC chip sales appears to be arriving later than expected. On its latest earnings call, Intel indicated that sell-in was roughly 10% below consumption for the full year 2022, with the first quarter 2023 undershipment representing "the most significant inventory digestion in our data set". We expect PC industry chip inventory depletion to persist into the second quarter, with help from actions taken by PC makers to lower prices and encourage sales to customers in sluggish end demand.

AMD's share gains in x86 chip sales helps blunt its client segment performance in an underwhelming PC market environment. In observing AMD's inventory, we believe it has taken actions to undership end demand earlier than its competitor. However, we believe enterprise IT budget and consumer spending will remain challenged in 2023. If Intel takes aggressive pricing actions to clear inventory, AMD will be faced with either matching them on its own products or risking losing sales.

Table 3

Smartphone

Similar to the PC market, smartphone sales also peaked in early 2022 on the back of 5G product releases. According to International Data Corp., smartphone units were down 11% in 2022, with Apple Inc. and Samsung Electronics Co. Ltd. down in the mid-single-digit percent area and Xiaomi Corp., OPPO, and Vivo S.A. down 20% or more. The declines accelerated in the fourth quarter with units down 18% year over year. Weak demand in China due to COVID-19 lockdowns weighed on results, particularly in the second half, but the high-end smartphone market was relatively resilient. In addition to unit weakness, smartphone makers are drawing down safety inventory they believe they no longer need as supply chains stabilize. We believe this correction is likely to conclude in the first half of 2023. We recognize that China smartphone makers are going through a more severe industry correction than Apple, but aggressive price cuts and new flagship smartphone releases in March and April should provide some relief. We expect full-year 2023 global smartphone unit shipments to be flattish, reflecting a better second half. Risks include diminishing consumer discretionary spending and an elongated smartphone upgrade cycle as a result.

We expect smartphone suppliers to operate with a one-quarter lag to unit sales. Inventory correction will continue to be the theme in the first half. The second half should increase more in line with industry unit shipments, with semiconductor sell-ins closer to sell-through. 5G content gains should continue, but the improvement would be more muted due to high market penetration. Qualcomm Inc. indicated that inventory correction is likely to continue in the second quarter with expected sell-through weaker than expected with slower China smartphone uptake to blame. Elevated inventory and macroeconomic uncertainty pose headwinds, though Qualcomm's market share gains with Samsung and others could partially offset some industry challenges. Qorvo Inc.'s revenue fell 20% year over year in the last reported six-month period. Skyworks Solutions Inc.'s fell only 3%, mostly because of its 58% exposure to Apple, whose performance was more resilient given focus on higher end smartphones, compared to Qorvo's 33%. For 2023, we expect the difference to persist, with Qorvo's revenue down about 25% and Skyworks' a relatively modest about 4%.

Table 4

Memory

The memory industry is mired in one of the deepest downturns in its history with weak end-market demand across PCs, smartphones, and data center coupled with extremely high customer and supplier inventory that has significantly impaired ASPs across DRAM and NAND. We believe first-quarter 2023 memory demand is perhaps weaker than initial company guidance, which we believe delays the inevitable recovery into late 2023 or early 2024. Despite most industry players reducing production, we believe first half 2023 operating results for all memory players will be extremely poor, with massive operating losses and significant free operating cash flow (FOCF) deficits despite capital expenditure (capex) reductions. In all, we believe DRAM bit growth will decline near the high-single-digit percents; NAND, because of demand elasticity, will increase in the low-single-digit percents, both significantly below their long-term growth rates. As for pricing, we believe DRAM ASPs will start to inflect in late 2023 and NAND will take longer into early 2024.

We expect inventory days to peak in the first or second quarter of 2023. We believe inventory has peaked in the PC and smartphone end markets but remains high among cloud customers. However, it should start declining given the significant production cuts announced by the likes of SK Hynix Inc. and Micron Technology Inc. The latter expects inventory days to exceed 200 in the fiscal second quarter (February 2023) with NAND being worse than DRAM. Micron further expects to end the fiscal year (August 2023) with still-high inventory above 150 days, well above the norm near 100 days. Recent capex announcements have no impact on the inventory problem due to the roughly two-year lead time it takes to hit production. Should the macroeconomic outlook deteriorate more than we forecast, denting consumer demand for PCs and smartphones, or China's recovery proves slower than expected, oversupply and hence elevated inventory will persist into 2024.

Table 5

Enterprise IT Spending Cyclical Downturn Is Less Worrisome; Auto And Industrial End Markets Are Resilient

Server

Responding to weaker macroeconomic conditions, hyperscale cloud service providers and web-scale companies such as Amazon.com Inc., Alphabet Inc., Microsoft Corp., and Meta Platforms Inc. are helping customers cut costs, which in turn leads to a cutback on their own server orders and data center buildouts. Given our expectation for more workloads to continue migrating from on-premises data centers to the cloud and secular growth in the double-digit percentage area, we anticipate spending cuts in the public cloud to last maybe two to three quarters. This inventory digestion period follows almost three years of accelerating cloud capital spending growth. These cloud service providers' procurement patterns tend to be lumpy, as they opportunistically purchase components in large quantities, leveraging their sizable purchases for best prices. This purchasing behavior would cause higher business volatility at their NAND memory, CPU, graphics processing unit (GPU), and server providers.

Demand for enterprise data center infrastructure, including private cloud, also slowed beginning in the calendar fourth quarter of 2022, with increased observations by Dell and Hewlett Packard Enterprise Co. (HPE) of deal pushouts. Both discussed that the server market is undergoing a normal digestion cycle likely to persist in 2023. We expect signs of recovery in server sales will highly depend on an improving macroeconomic outlook.

Table 6

Data center chip suppliers

Revenue growth at hyperscale cloud service providers such as Amazon Web Services (AWS), Microsoft Azure, and Google Cloud Platform decelerated in the second half of 2022. These companies reduced their data center infrastructure spending, hurting suppliers such as Nvidia Corp., Intel, AMD, and Marvell Technology Inc. Also, enterprise data center spending is waning as IT budgets tighten. We expect hyperscale cloud spending growth to inflect, likely in the third quarter, sooner than enterprise data center spending based on data center chip vendors' commentaries and the historical pattern of inventory digestion that tends to last only three to four quarters. Whereas enterprise data center spending recovery is still highly uncertain, catalysts could come from AMD's release of Genoa-X and Bergamo in the first half of 2023 and Siena and Instinct MI300 in the second half, and Intel's release of its next generation server processor Emerald Rapids anticipated in the fourth quarter.

Nvidia's data center segment revenue growth decelerated to 11% year over year in the January 2023 quarter from 83% in the April 2022 quarter. Its inventory also dramatically increased throughout its fiscal year ended January 2023. We find Nvidia's inventory buildup to be strategic and includes much of its new Hopper GPU that the company correctly, in our opinion, views will be sought by hyperscale cloud customers. AI appears to be at an inflection point and Nvidia poised to benefit from increasing sales of its most advanced GPU chips, which are specialized processors optimized for running artificial intelligent workloads such as deep learning and natural language processing. Intel and AMD also sell AI accelerator chips, but we believe Nvidia will be the main beneficiary given the technical capabilities of GPUs that are better suited than CPUs to solve complex processing tasks quicker. They are preferred in higher performance computing and AI applications. Nvidia has a long track record of leadership in GPU development.

Intel's data center and AI segment revenue declined dramatically beginning in the June 2022 quarter, and we anticipate the softness will continue over in the first half of 2023 given inventory overhang. The weakness can be partly explained by the macroeconomic weakness prompting customers to adjust inventory accordingly and market share losses to its main competitor AMD. We expect this will persist through 2024 based on the timeline of Intel's process technology roadmap and, to a much lesser extent, the gradual adoption of arm-based chips going into data centers used by hyperscale cloud providers. We believe Intel's exposure to the China enterprise segment is greater than its competitors', so a rebound in China reopening would hasten the inventory digestion phase and allow growth sooner.

AMD's data center segment continues to expand rapidly but markedly slower than prior expectations. Similar to Intel and Nvidia, ongoing inventory correction in cloud and tighter purse strings at enterprise customers constrain data center revenue growth. However, we expect AMD to build on its competitive strength in high performance computing to continue market share gains in server CPUs and, to a lesser extent, in AI accelerators.

Table 7

External storage

Data is increasing at an exponential rate and stored on more devices, applications and platforms, which is favorable to branded storage systems providers such as Dell, HPE, and NetApp Inc. However, branded storage systems are considered on-premises data center infrastructure, for the most part, because cloud service providers, given their scale, prefer to build their own to suit specific needs and avoid having to pay for branded equipment. This will continue to be a challenge faced by branded storage system vendors as more and more workloads continue to migrate to the cloud. To combat this, storage vendors are including more functionalities and value-added intellectual property to their products, as well as offering them in managed service deployment models comparable to those offered by cloud service providers. Among these branded storage vendors, NetApp is considered the most cloud-friendly with the longest track record partnering with public cloud providers AWS, Microsoft Azure, and Google Cloud Platform.

Dell and HPE do not break out their inventory for storage, but we do not believe they are elevated. Storage sales have been fairly steady the past two years until recently, when lengthening sales cycles, smaller deal sizes, and price competition became more prevalent with tighter IT budgets. After reporting a strong fourth-quarter 2023 performance in its storage segment, Dell indicated early signs of weakening demand, particularly among small and midsize businesses. NetApp expects better growth in cloud storage as new and existing workloads continue to move to the cloud. However, customers are facing incremental IT budget constraints, hurting overall product demand. We expect the external storage market to show cyclical weakness over the next two quarters, but with less volatility compared to the server market.

Table 8

Hard disk drive (HDD)

The HDD industry has changed rapidly over the past several years from one heavily reliant on PC volume to one driven by hyperscale data center demand. For example, Seagate Technology Inc. got 43% of its HDD revenue from mass capacity drives (those used by hyperscale cloud service providers) in the December 2018 quarter but 75% this past quarter. This has been a mostly favorable development because we now view HDD as a growth industry, whereas before we thought it might be in secular decline. The industry has become more concentrated among hyperscale cloud service providers and short-term performance suffers from customer inventory correction. Industry revenues peaked in the second half of 2021 as supply chains were constrained, prompting hyperscale cloud service providers to build safety stocks, which kept volumes high and pricing firm. During the second half of 2022, that trend reversed as hyperscale cloud service providers drew down safety stocks as supply chains stabilized. Seagate's revenues fell below its normal range and gross margin to the low-20% area in the fourth quarter, below the 25%-30% barrier of recent years.

Macroeconomic weakness entering 2023 is compounding the inventory correction as hyperscale cloud service providers reduce capital spending. We expect the HDD industry inventory correction to continue through the first half and return to the normal range in the second half. We attribute the recent industry challenges from unprecedented gyrations in supply chains to the COVID-19 pandemic. We expect the HDD industry inventory digestion phases to only last two or three more quarters. We expect HDD to remain a growth market as hyperscaler cloud service providers continue to face strong double-digit percent growth that will require HDD investments.

Networking

Supply chain constraints at networking equipment companies such as Cisco Systems Inc., Juniper Networks Inc., and HPE date to 2020. Inventory (work in progress) has been rising rather substantially since, quarter after quarter. Certain components remain highly constrained, but improvement is evident from actions taken by supply chain and engineering teams to redesign products that help increase product deliveries and reduce customer lead times, according to Cisco. The companies' healthy backlog and pipeline suggest relief from supply chain constraints can help aggressively reduce inventory on hand, without write-downs.

Table 9

All three companies are guiding to accelerating networking equipment revenue growth next quarter, a reflection of improving component availability and allowing for faster product shipments. However, order trends have been down since mid-2022 at Cisco and Juniper, and customers have expressed spending may be slowing. This raises concerns as we head into a weakening demand environment. Still, in an ever more connected world, we view favorably the longer-term growth trajectory of the networking equipment industry. We believe it will remain cyclical but less affected by the workload transition from on-premises data centers to the cloud. Additional avenues for growth include security offerings that these companies have prominently featured. Cisco and HPE have also shifted their business models to include more software-centric as-a-service products, rather than relying on traditional equipment sales, which is increasingly preferred by customers.

Auto

The automotive sector has been one of the hardest hit by disruptions in supplies of key components the past few years. The automakers and their tier 1 suppliers' decision to cancel chip orders in reaction to the COVID-19 outbreak in early 2020 was prudent at first given the expectation for a shutdown in auto manufacturing and an economic collapse that should dampen consumer spending. Demand ended up surging later that year, and the manufacturing capacity for auto chip production was reallocated to other consumer electronics as the pandemic-induced lockdown globally lifted demand for goods over services. Complicating matters is that auto chips tend to be made using trailing-edge technologies. Chip manufacturers' incentive to allocate capacity for lower-margin products in a tight supply environment is low. The severe chip and component shortage hurt automakers, prompting them to stockpile inventory when possible and prioritize production of higher-end cars, including electric vehicles. Fortunately for the auto chipmakers such as Texas Instruments Inc., NXP Semiconductors N.V., ON Semiconductor Corp., and Microchip Technology Inc. and connector vendors such as TE Connectivity Ltd. and Amphenol Corp., these higher-end vehicles tend to also have more electronic content such as advanced driver assistance systems, digital dashboard, entertainment systems and connectivity features as well as more sensors that lift sales, prices, orders, and backlogs despite lower global vehicle production in 2020-2022.

Severe auto supply chain tightness is showing early signs of returning to normal. Auto chipmakers have reported that orders with 52-week lead times have started to decline, affirming that supply conditions remain stressed. Progress is being made toward a healthier demand-supply balance. Also, chip inventory oversupply is not concerning in the auto supply chain, in our view. NXP indicated it is prudently lowering its manufacturing factory utilization rate to about 85% in the first quarter 2023, down from low-90% in the fourth quarter of 2022 and higher in prior quarters, to proactively control inventory at distribution channels.

S&P Global Mobility expects light vehicle production to increase 3% in 2023 and 4% in 2024, higher than the flattish growth in 2022, which should help auto chipmakers and connector vendors clear some backlog and sustain a growth trajectory for longer.

Distributors and EMS providers

Inventory was well managed over the past few years and now sits only slightly higher than longer-term medians. Broadline electronics distributors such as Arrow Electronics Inc., Avnet Inc., TD Synnex Corp. and Ingram Micro Inc. are skilled operators that meet their customers' needs and manage inventory with suppliers.

Over the past few years, distributors played an even more important role when manufacturers and equipment designers often found themselves facing parts shortages and lack the "golden screw"--an elusive part needed to complete a project. Distributors helped their customers scour the vast supply network for the exact parts or alternatives that can perform the same function. Distributors can be mistakenly viewed as low margin commoditized service providers. However, we view them as important middlemen, helping suppliers and manufacturers focus on their competitive strengths and relieve them of serving certain customer cross-sections (i.e., small to midsize customers) and help untangle global logistical complexities.

EMS inventory has been much higher over the past three years compared to historical averages. There was inventory buildup in anticipation of continued end-demand growth, which provides reasons to worry. However, we don't believe that is the entire story. We believe some of the inventory buildup also relates to "golden screw" issues with the auto segment, but concerns will dissipate as auto demand remains healthy and supply chain constraints ease. Additionally, customers have also made advances tied to orders, which gives EMS providers assurance that the purchases are less likely to be for speculative growth. We believe managing geopolitical risks becomes a higher priority for the tech supply chain, the broad manufacturing footprint and experience with managing supply chain complexities and EMS providers will make their outsourced manufacturing services even more sought.

What About Non-Cancellable, Non-Refundable Contracts?

Non-cancellable, non-refundable (NCNR) contracts were used more frequently over the last few years, but they are not new to the semiconductor industry. NCNRs are binding agreements typically between foundries or chip manufacturers Taiwan Semiconductor Manufacturing Co. Ltd. and Samsung, and their customers. But there are also instances of fabless chip companies, i.e. Broadcom Corp., entering into NCNR agreements with customers. Wafer fabs are becoming increasingly expensive--leading-edge fabs cost upward of $20 billion to build and equip--foundries and chip manufacturers are demanding that fabless customers (Qualcomm, AMD, and Nvidia) bear some of the financial burden by signing multiyear NCNRs. In some cases, they want customers to prepay some amount for guaranteed capacity procurement.

These contracts are not isolated to leading-edge chipmaking either. Some manufacturers of lagging-edge semiconductors, typically referred to those at process nodes over 28 nanometers (nm), such as Microchip Technology (not rated), have also introduced NCNR agreements with customers over the past few years as the COVID-19-induced supply chain disruptions have created conditions such as demand significantly outstripping supply and double ordering. This was especially evident in the auto end market when electronic content dramatically increased with new features such as new advanced driver assistance systems, digital dashboards, entertainment systems, and connectivity were must-haves.

We believe NCNR contracts are here to stay because foundries and chip manufacturers are viewed more strategically to the chipmaking process. This is apparent in General Motors Co.'s (GM) agreement with GlobalFoundries this year to establish a dedicated capacity corridor in which GlobalFoundries will manufacture for GM's key chip suppliers. This agreement may also be influenced by the desire to reduce the reliance on Asia-based semiconductor supply and the need for more western sources.

Chip manufacturing costs, both fab construction and equipment, are rising and ever more prohibitive for leading- or lagging-edge nodes. Manufacturing capacity still appears constrained compared to forecast longer-term demand. We view the announced capacity expansion plans by TSMC, Samsung, Intel, Micron, Texas Instruments, and others to be necessary to meet the rise in demand over the next few years. Meanwhile, the anticipated capacity increase won't be available until at least years later given the lag from construction to chip output, which is a plus because of our view of slower economic growth, if not a recession, on the horizon.

Will Inventory Drop To Historical Averages And Lower, Or Will There Be More Safety Stock?

The macroeconomic environment, geopolitical risks, supply constraints, and customer behavior are important factors, sometimes competing, in determining whether the elevated inventory in the tech supply chain will revert to areas closer to historical averages or behave differently. Experience tells us that elevated inventory declines to below historical trends are not limited to recessionary environments, including 2001-2022 and 2007-2009 (charts 1, 2, and 3). In 2018, the global economic slowdown, disruptive U.S.-China trade spat, and U.S. Federal Reserve monetary policy tightening contributed to a spike in tech supply chain inventory. However, the reversal was to the trend line, not worse, because of the uncertainty related to the ongoing U.S.-China trade concerns and the desire to hold safety stock.

We find the environment like 2018. Decelerating macroeconomic growth is the driving force for a sharp decline in inventory and manufacturing facility production. But support for inventory could come from rising geopolitical tension, reducing reliance in China and, in general, Asia-Pacific chip manufacturing, and increasing electronic content in secular growth areas such as cloud computing, digital transformation, artificial intelligence, and auto electrification.

Perfect Storm: Protracted Macroeconomic Weakness And A Weaker China Rebound Are Catalysts For A Broader Rating Downtrend

We continue to view longer-term industry growth drivers intact. Cloud computing, digital transformation, automation, auto electrification, and broader adoption of technology in all end markets will continue to drive electronic content growth. We expect next-generation cloud computing will require greater processing power and more of it at the network edge, requiring faster connectivity. We also expect increasing use cases for machine learning, AI, and data growth to boost demand for compute, server, and storage longer term.

We have a generally positive long-term outlook for the tech sector, but cyclicality could be magnified if a recession ensues. Signs point to a higher chance of recession with recent failed banks in the U.S. and Europe, rising geopolitical risk, and persistent high inflation and interest rates.

Geopolitical uncertainties are intensifying.  The ongoing tensions between China and the U.S. have added more questions about their relations. While widespread negative rating actions stemming from tightening U.S. controls and trade wars have not happened the prospects for a longer-term diversification strategy may have lasting implications for the sector. This may mean increased regionalization of supply chains in other Asia-Pacific regions or onshoring in the U.S., Europe, and elsewhere. This shift may improve supply chain resiliency but reduced efficiency and higher costs are likely to hurt profits, especially over the next year or so.

There is a higher probability of recession if credit conditions tighten.  We expect consumer and business sentiment are most likely to be affected by the U.S. regional banking concerns and other large failures such as Credit Suisse. It is reasonable to expect credit conditions to tighten, reducing IT spending, with the only question being by how much. Our base case is for the economy to enter a shallow and brief recession, however the risk is higher and timing could be sooner given recent developments.

China demand has a slow rebound.  China's zero-COVID policy hit consumer spending and spread to technology companies operating in the country, but the relaxation of these polices should have the opposite effect on its economy. Recent indicators show improved consumption but more sluggish than anticipated. The recovery will be closely watched as it may stall as many sectors, including their most important consumer and property sectors, remain fragile. A slower Chinese economic rebound could constrain the growth trajectory of global PCs, smartphones, auto and industrial end markets, in our view.

Investment-grade ratings are generally stable, though we don't rule out negative rating actions.  Supply chain disruptions, tariffs, and a demand spike following the COVID-19 pandemic outbreak contributed to persistent inflation that is unlikely to completely abate this year. Companies' ability to pass along higher costs to customers will likely be increasingly difficult as the macroeconomic environment deteriorates and weighs on end customer demand. Firms have already announced actions such as cost-cutting measures, including headcount reductions and manufacturing optimizations, to cope with likely margin pressures. Still, we expect growth in revenue, profit dollars, and margins to be challenged. Even though companies have outlined plans to work down inventory this year and hit free cash flow (FCF) targets, we expect trends will be below historical norms (chart 4).

Chart 4

U.S. technology hardware and semiconductor credit ratings are skewed to stable outlooks (chart 5), on 82% of issuer credit ratings. Although few credits have a negative outlook, this doesn't suggest our view of the sector is immune to inventory challenges. Most at risk are those with reduced cushion at the rating and facing mounting business pressures or structural industry challenges to withstand a worse than expected downturn.

Chart 5

While we view higher rated issuers generally have stronger balance sheets to offset periods of weakness; industry weakness may decrease U.S. technology hardware and semiconductor rating cushion. We lowered our rating on Intel to 'A' from 'A-' and revised our outlook to negative in February 2023. Weaker-than-anticipated PC and server chip demand in 2023 and continued market share loss to AMD, especially in the server end market, could persist through 2024. Additionally, its significant capital spending requirements, which we believe are necessary to regain its technology and product leadership, will result in FOCF deficits in 2023 and 2024.

We revised our outlook on Micron to stable from negative and affirmed our 'BBB-' rating in December 2022. Micron was on the path to a higher rating, but the deep correction in memory supply and ASPs and our presumption of lower industry volatility was invalidated, leading to our outlook revision to stable. The company announced aggressive capex cuts to match industry demand and anticipates strong ASP erosion. We lowered our rating on Western Digital Corp. to 'BB' from 'BB+' in November 2022 given severe price and unit sales weakness in its flash memory segment and its cloud customer inventory digestion, leading to lower HDD sales.

Table 10

We think the significant revenue and orders growth over the past two years may foreshadow a deeper correction and slower recovery, raising rating pressure for hardware and semiconductor issuers. Here, we focus on higher-rated hardware and semiconductor credits, with which we see potential for business underperformance considering the challenging environment. Additionally, those already facing challenges amid technological disruption may be even more challenged with macroeconomic headwinds. The unprecedented rise in semiconductor inventory days followed by a rapid reversion to the longer-term trend line as seen in 2008, 2012, and 2019 may signal a period of weaker credit metrics for the U.S. technology hardware and semiconductor sectors (chart 1). We do not predict widespread downgrades, however some companies have less rating cushion and will likely be more affected amid a snapback from inventory well above the historical trend.

The normalization of inventory forces suppliers and component makers to reduce inventory aggressively and manage price concessions to aid the rebalancing of excess stock over the next couple of quarters. As such, we expect revenues, margins, and FCF may deteriorate significantly as inventory conditions worsen. A mixture of lower sales volumes, ASP pressures, and factory underutilization could spell trouble for suppliers and manufacturers, likely increasing the risk of weaker than expected profitability and greater FCF pressures.

Table 11